Why Pre-Seed Stage Valuations are Falling

Why Pre-Seed Stage Valuations are Falling

The partners at Right Side Capital Management (RSCM), a micro venture capital fund focused on pre-seed stage investments, have made an interesting observation recently about valuations of early stage companies: While the valuations of companies raising money at the Series A stage or later have risen substantially over the past few years, the valuations of pre-seed stage companies have fallen. More importantly, they think the reason is basic economics: a simple imbalance of supply and demand for capital at the pre-seed stage.

As the partners at RSCM have identified, and I have reiterated ion this site, the cost of developing a new software product has dropped substantially in recent years. Because software companies account for nearly 40 percent of all businesses seeking financing from business angels and venture capitalists, this decline in product development cost has led to a dramatic increase in the number of companies seeking small (less than half a million) pre-seed stage financing rounds.

This increase in demand for capital has not been met with a corresponding increase in the supply of capital by angel investors. (At the pre-seed stage virtually all capital is provided by business angels; venture capitalists tend not to invest this early because the transaction costs of their investments are too high for small rounds.)

Why aren’t angels providing more capital at this very early stage? The partners at RSCM think that the answer lies in how the typical angel makes investment decisions.

The typical angel invests as follows: The financier hears about a business seeking financing. The investor looks at the focal company’s industry sector, its founders, and the business idea, typically comparing the venture against others in which he or she could invest, and picking the most desirable one to support.

The problem with this approach is that individual angels rarely set the price and almost never lead deals. Therefore, when they decide to invest in companies, they make soft commitments that require the founders to find an investor who will set the price and lead the round.

But the investors who will set the price and lead the round are few and far between at the pre-seed stage. Venture capitalists who will set the price and lead a round, rarely invest at the pre-seed stage. Accelerators who do invest at this stage and will set the price, tend to purchase common stock and rarely allow other investors to invest on their terms. Angel groups will also set a valuation, but they tend not to like pre-seed stage deals because the greater uncertainty of these investments makes it more difficult to obtain the consensus of group members.

Moreover, at the pre-seed stage, the high ratio soft commitments to hard commitments makes it even more difficult to find an investor to lead the round and set the price. The greater the number of soft commitments, the more pressure there is on the lead investor to value the company correctly. Of course, the more pressure the investors face to value a company correctly, the fewer the number of investors who will take the chance of mispricing a round.

In short, angel investors’ decision making processes make it difficult for them to move earlier in the financing process. As demand for capital has risen at the pre-seed stage, this market inefficiency has led to too much demand and too little supply of financing, causing its price — the valuation of pre-seed stage companies – to decline even as valuations of later stage businesses have increased.

Down Value Photo via Shutterstock

Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.